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Thursday, December 25, 2008

“In Ukraine, the evidence is still that policymakers do not quite understand the seriousness of the challenges they face,”. Timothy Ash, analyst at the Royal Bank of Scotland.

“There is a burgeoning economic crisis in the European periphery,” Krugman said on the ABC network Dec. 14. “The money has dried up. That’s the new center, the center of this crisis has moved from the U.S. housing market to the European periphery.”

Make no mistake about it. What is taking place right now in Ukraine is extraordinarily serious. The IMF have recently agreed a support loan to the country, but the politicians themselves still can't agree on whether or not they are actually going to abide by the conditions attached to it. Meantime, as we can all see on our TV screens, tensions with Russia continue to escalate, fuelled by the conflict-ridden negotiations over Ukraine's gas debt.

And just to add to the nighmare, Ukrain's economy made a dramatic entry into recession in Q4 2008. In fact, so severe has been the slowdown that nobody at this point can even muster enthusiasm for opening up one of those interminable discussions about whether or not what the country is going through really counts as a "technical recession" (in terms of two successive quarters of GDP contraction) or not, since the drop in national output has been enormous, and it it fairly obvious that isn't about to come bouncing back up again. At least not for the next several quarters it isn't, and - to give us an early glimpse of the terrain onto which we are now entering - the World Bank have just forecast a 4% contraction in GDP for 2009.

In a year when you would think little would surprise us the sharp change in real Ukraine GDP dynamics has been astonsihingly swift, with the growth rate moving from the 11% year on year expansion registered in August to the 14% year on year contraction reported in November (according to data put together by the World Bank). GDP for the whole January-November period is now down to 3.6% when compared with the equivalent months in 2007, and this is reall a sharp drop, since the average over the first nine months of the year was a growth rate of 6.9%. For his part the office of Ukraine President Viktor Yushchenko is suggesting that gross domestic product may contract at an annual rate of between 7 percent and 10 percent in the first quarter of next year, and by 5 percent over the whole year, according to Oleksandr Shlapak, deputy chief of staff to the president.

The contraction has been led by sharp falls in manufacturing and construction, while the financial system has been in serious trouble since late September, and the loss of UAH deposits from the banking system has amounted to 14% during October and November. But the real problems Ukraine is facing in confronting this most serious economic crisis, lieas in the political sphere, and the complete lack of the kind of political consensus which is so necessary to see through the measures which can it to an end.

Political Chaos Adds To The Problems

Ukraine’s government - which is laways a chaotic process at the best of times - is once more having a serious identity crisis about who it is and what it wants to do, with one of the exectutive's two visible hydra's heads (Prime Minister Yulia Timoshenko) seeking to respond by manipulating the currency downwards, by boosting social expenditure to an extent which will push next year’s budget deficit up to 2.96 percent of gross domestic product (from an agreed 1.4%) and well beyond the IMF pact level, and by attempting to resolve the trade deficit problem by imposing an administrative tax on imports. The other head of the hydra (President Viktor Yushchenko) is busy opposing all these moves on the grounds that they may jeopardize the second tranche of a $16.4 billion loan from the International Monetary Fund, and obviously, were this to be the case, the country would basically find itself bankrupt, and at the mercy of whatever sentiments the global financial markets wish to express when it comes to Ukraine.

Of course regular readers of this blog will not be surprised to find that this politically split personality crisis goes right into the heart of the central bank (see my Monetary Chaos Breaks Out At the Ukraine Central Bank post) and no one will be really that surprised to find that the two key characters in this round of the saga are (yet one more time, read the linked post, its all explained there) National Bank of Ukraine Governor (and board chairman) Volodymyr Stelmakh’s and Petro Poroshenko head of the central bank council.

Well things are really hotting up at the moment, with Viktor Yushchenko this week threatening to fire some central bank employees (presumeably those who were not implementing the decision to allow the Hryvnia to float), while Yulia Timoshenko was busy demanding the dismissal of National Bank Volodymyr Stelmakh himself - presumeably because he was trying to stop further currency intervention. In an official statement the central bank council responded by accusing Timoshenko of stirring up “chaos” and undermining the nation’s banking system, while Timoshenko, for her part has now taken the matter to the Ukrainian parliament (the Verkhovna Rada - where she may well carry a majority) which will now hold a full debate the role of the central bank next week. It seems not to matter too much here that the bank council is simply trying trying to implement a set of policies which were agreed to (or everyone thought they were agreed to) as part of the IMF loan agreement.

“A hryvnia level above 9 per dollar is unacceptable, it threatens the economy and banking system,” Petro Poroshenko, the head of the central bank council said. “The situation with the hryvnia rate demands urgent measures.”

(Interfax-Ukraine) - Yulia Tymoshenko Bloc has proposed that, based on results of a report by an ad hoc parliamentary commission scrutinizing the National Bank of Ukraine's activities, an address should be sent to the Prosecutor General's Office and that National Bank Chairman Volodymyr Stelmakh should be arrested. "I think that, based on the report's findings, there will surely be an address to the Prosecutor General's Office of Ukraine and other law enforcement agencies, which, by the way, are already conducting inquiries," Volodymyr Pylypenko of the Yulia Tymoshenko Bloc said in an interview with Interfax on Wednesday. "The best gift in this situation can only be an order on taking [National Bank of Ukraine Chairman Stelmakh] into custody for all wrongdoings the National Bank has committed in the past months," Pylypenko said.

President Yushchenko did express the hope last Tuesday that Ukraine's currency market might be moving rightside up, with the hryvnia trading at about 7.8-8.0 to the dollar and level of "stabilising" dollar purchases by the central bankdeclining, but Prime Minister Tymoshenko remained unconvinced that this was a desireable level, and demanded more concerted intervention to move the currency up to a much higher level - around the 6-6.5 to the $ mark. She gave Yushchenko a week-and-a-half apparently, since otherwise she stated the country would face increasing problems with inflation, and in the banking and other sectors. It is not clear (at least to me) why these problems (which are, and will continue to be, serious) should suddenly deteriorate within the time scale of ten days, but presumeably there was another, more political, message behind this choice of words.

Adding to the confusion, Ukraine's parliament, has decided to impose an additional 13% temporary duty on all imported goods - and this despite the fact that Ukraine only recently entered the WTO. A total of 269 MPs from the ruling coalition and the Communist Party voted for the relevant law which amended existing Ukranian lefislation - with, it was said, the aim of improving the state of Ukraine's balance of payments. "Duties have been increased on all imported goods, apart from a [so-called] 'critical' [list of goods]," the head of the parliament's committee for tax and customs policies, Serhiy Teriokhin, is quoted as saying.

"I'm alarmed by the report of my legal department on parliament's decision to impose an additional temporary duty on all imported goods. Parliament's decision puts Ukraine's presence in international programs in jeopardy," President Yushchenko said at a press conference yesterday. "Similar decisions by Russia and Europe might be made against us in three days,".

IMF Taking Large Political Risk

Last month, a point in time which now seems so distant it feels like eternity, Ukraine received approval for a two-year IMF loan intended to help support its banking system and cover the country’s widening current-account gap during what was always seen as being a difficult adjustment process. Under the terms of its agreement with the IMF, Ukraine is expected to have a balanced budget next year. If the Cabinet fails to meet the target, then the Fund may withhold the second tranche of the loan, according to press statements by Balazs Horvath, IMF representative in Kiev. Ukraine received the first installment of $4.5 billion last month, and is due to get the second tranche in February. Obviously the IMF is by now well accustomed to playing the part of the "bad boy" in this type of situation, but what if the country they are trying to deal with should simply "implode", right in its face, I'm not sure even the hardened hand of the IMF are ready for this. So let's just hope I'm exaggerating, and that it won't happen (fingers tightly crossed everyone, please).

Discrepant GDP Forecasts

So Ukraine faces a crisis on three fronts, financial, economic and political. On the real economy side, the Ukraine cabinet currently expects growth in the country’s economy to slow to 0.4 percent next year, compared with a final rate which turn out to be somewhere between 1.8 percent and 2.5 percent this year. As I say the World Bank now expects a 4% contraction in GDP next year, and thus a 0.4% expansion in the budget is potentially a very serious problem indeed for the deficit, if the economy underperforms, as it surely will.

“The draft budget, prepared by the Cabinet, is not realistic,” Yushchenko said today in a statement on his Web site. “The 2009 budget is a tragedy; it is the most irresponsible document worked out by the government. Professionals should plan a realistic budget, not optimistic.”

The government plans to cover the budget deficit by selling bonds in domestic and foreign markets, and is to receive a $500 million loan from the World Bank to cover the budget deficit. Under the terms of the IMF agreement with the Inernational Monetary Fund Ukraine has pledged to keep its 2009 budget deficit under 1 percent of gross domestic product, below the 2 percent initially planned by the government. In October, the government reduced its planned 2008 budget revenue from the sale of state assets to 401 million hryvnia ($59.4 million) from 8.6 billion hryvnia, citing the unfavourability of the moment for selling.

Pressure On The Hryvnia

The Hyrvnia has been falling for a number of weeks, but the rate of decline has really accelerated in the last ten days, and we are really now talking about one of those famous currency crises. The national currency has fallen 50 percent against the dollar since June, and according to Michael Ganske, head of emerging markets in London for Commerzbank, it may well drop another 24 percent in the next few weeks given market sentiment and that the International Monetary Fund package effectively limits central bank intervention to halt the slide. The terms of the IMF $16.4 billion bailout package, agreed to last month, require Ukraine to move toward a flexible exchange rate and place a maximum limit of 4 percent for any reserves reduction during the remainder of 2008 (from the base of around $32.8 billion). Thus while the agreement does allow intervention to stem “disorderly” swings, it places a tight limit on what this means. And this now is just the problem, although before we jump to our guns, we should bear in mind that what is provoking the fall is not the IMF and the bailout, but confidence in the ability of the political system to implement a workable recovery plan. Trying to run a currency corridor, and accepting the inflation that went with it, is how we got here in the first place.

The only real remedy Ukraine’s central bank has at its disposal at this point is to raise its base refinancing rate, and this it duly did last week, taking it up from 18 percent to 22 percent in an attempt to arrest the hryvnia’s decline To give us some idea where we are at this point, at the start of 2008 the dollar bought 5.04 hryvnia, while right now it can purchase around 8.25 hryvnia.

The central bank is currently offering to sell dollars at 8.0 hryvnias and to buy them at 7.8788 on the interbank market. Yushchenko told a news conference last week that the central bank had bought $270 million on Monday and Tuesday, but had been required to sell only $30 million on Tuesday. He informed the assembled journalists, however, that complete stabilisation would need to wait until after the debts for Russian gas and other expenditures had been paid (you should be able to start to smell just how complicated all this is by this point, just who exactly is batting for who here?). "Until debts are paid for gas, and settling the debts of (the national road network) Ukravtodor, it would be madness to talk about steps aimed at a fundamental, professional stabilisation". "Everything is earmarked", he claimed, "$3 billion (for intervention from reserves), more than $2 billion set aside for gas arrears, $1 billion for repayment of a loan to Ukravtodorom, $200 million to (rocket maker) Yuzhmazh, leaves only an additional $400 million to defend the hryvnia."

As a result of the $7.5 billion the Ukraine central bank spent supporting the hryvnia in October and November foreign reserves fell to $32.7 billion as of Nov. 30. At the same time the hryvnia has declined 21 percent against the dollar over the last month alone . Under the terms of the agreement with the IMF, the reserves should not fall below $31.4 billion by the end of this year, so we are talking about a very close call on this front too.

Equities Down And Credit Default Swaps Up

Ukraine’s stocks have also been falling, and the benchmark PFTS stock index is down 74 percent this year, the third-steepest decline among the 22 so-called frontier markets tracked by MSCI Barra. Mariupolsky Metallurgical Plant, Ukraine’s largest steel company by revenue, has fallen 92 percent on the Kiev stock market. On the other hand the extra yield investors demand to own Ukrainian government bonds instead of U.S. Treasuries has increased more than nine times this year to 25.86 percentage points, according to JPMorgan Chase’s EMBI+ indexes, which compares with an average three-fold increase in the main emerging-market index to 7.09 percentage points.

Loan Defaults Coming

And as the currency slides, so too does the ability of the average Ukrainian to pay his or her debts. Another Yushchenko aide, Roman Zhukovskyi, recently estimated that up to 60 percent of foreign-currency loans and mortgages could default given the extent of the decline. Ukraine, which has around $105 billion in corporate and state debt, has the fourth-highest credit risk worldwide, according to credit-default swap data. The cost of insuring Ukraine bonds against default is up more than thirteenfold this year, to an astonishing 31 percent of the amount of debt protected. This puts the country behind only Ecuador, which defaulted last week (59 percent), Argentina, which defaulted on $95 billion in bonds in 2001 (46 percent), and Venezuala ( 33) percent, according to the data from CMA Datavision.

Ukrainian companies need to repay as much as $4.1 billion this month while lenders refuse to refinance debt, according to Dmitry Gourov, an economist at UniCredit in Vienna (oh, no, not Unicredit again, see this post). Dollar denominated loans made up 53 percent of credit issued by Ukrainian banks as of 30 September, according to central bank data.

Thus, with just over half of all bank loans denominated in US dollars, they obviously become vastly more expensive for borrowers who are paid in the national currency.

Aggressive lending by banks that borrowed heavily from abroad has obviously contributed to Ukraine’s ballooning private sector external debt (currently estimated at $85 billion). Official figures indicate that only some 2.5 percent of loans are currently problematic, but this situation is obviously about to worsen considerably next year as the currency is down and the economy contracting.

Earlier this month, Finance Minister Victor Pynzenyk called on banks to refinance loans amid a weakening hryvnia and rising interest rates. Some banks in recent days said they would seek compromises with clients, rather than hike interest rates further. Pynzenyk’s proposal called on the NBU to amend its rules to allow borrowers either partially or in whole to pay back loans in the national currency at the exchange rate which was operative when the loan agreement was signed. The banks, in turn, would be allowed to lower their capital/asset ratios and write off their losses, thus paying lower taxes, which would also require amendments to the tax legislation. Obviously some such solution will need to be found for this problem. (There has already been some move in this direction in Hungary, another of the countries which is strongly affected by the forex loans problem).

Other measures under consideration at the present time include extending loan periods, and the temporary reductions in loan payment installments. If the hryvnia-dollar exchange rate further widens, mass loan defaults are inevitable, according to Yuriy Belinsky, head analyst at Astrum Investment Management. At the current Hr 8 to the $1 rate, “40 percent won’t be able to pay their loans,” Belinsky told Korrespondent, a Russian-language Ukraine newspaper.

And the situation is deteriorating fast, a quick visit to the foreclosure sections on the websites of banks like Finance and Credit Bank or Alfa will turn up plenty of property and cars already listed for sale or soon to be auctioned. But given the slump in the real estate market and falling house prices it isn't clear that banks will find it any too easy unloading any property they do repossess. We are back to the "you owe them a little money and you have a problem, and you owe them a lot of money and they have a problem" situation. Last weekend, the NBU also recommended that banks lower interest rates on foreign-currency denominated loans, but the problem is going to be, as ever, who is actually going to fund these measures?

Industrial Output Plummets

Meantime in the world of the real economy things simply get worse and worse. Industrial production shrank by a record 28.6 percent in November as steel, machine building and oil refining slumped, after a 19.8 percent decline in October.

And as output falls, prices come tumbling behind. Steel production dropped 48.8 percent in November, while the price of the benckmark European hot rolled coil has fallen 47 percent since August and is now at around $425 a metric ton, according to data from U.K. industry publication Metal Bulletin.

World Bank Forecast

The World Bank have predicted a sharp recession for Ukraine in 2009, with GDP being expected to fall by some 4.0 percent. This compares with their July forecast of 4.5 percent growth. The Bank also cut back its forecast for 2008 growth to 2.3 percent from a previously forecast 6.0 percent. It raised its inflation forecast for this year to 22.8 percent from 21.5 percent previously predicted, up from 16.6 percent in 2007. It cut its forecast for inflation next year to 13.6 percent from 15.3 percent.

(please click on image for better viewing)

The Bank take the view that the Ukraine government - in agreeing to the terms of the IMF loan package - have initiated an important programme of macroeconomic adjustment measures, but (with a wary eye on what is actually going on in the Parliament) stress that consistent implementation is essential to avoid a further erosion of market confidence. In their latest report the Bank highlight the shift towards a flexible exchange rate policy, financial sector stabilisation measures , and a more conservative fiscal policy, but as we have seen, these are just the measures which seem to be being challenged by some of the political participants .

So What Does The Future Look Like?

Obviously Ukraine is heading into a major recession in 2009 fuelled by the nasty cocktail of a credit crunch, a terms of trade deterioration, and a consequent massive slowdown in both internal and export demand. Given the damage to competitiveness caused by two years of double digit inflation, macroeconomic stabilization will require a very large and significant correction, and this will mean a significant tightening of aggregate demand and a shift in its composition away from domestic consumption and towards net exports. The government debt stock is currently low at 10 percent of GDP, and will undoubtedly remain sustainable throughout and after the adjustment, even allowing for the potential costs of bank recapitalization. But the ability of the Ukraine administration to carry out the necessary adjustment hinges critically on the willingness of external creditors to refinance the banking and corporate sector debts, and this willingness in its turn depends on the perception those creditors have of the level of political coherence and stability the country has. And as we are seeing such perceptions must be reasonably near an all time low at the present time.

But even with the best political system in the world, the economic correction facing Ukraine is going to be large and the stresses enormous. The World Bank more or less spell this out in the paragraph I extract below. A 200% contraction in real imports (ie not due to cheaper energy prices or something) is massive, and we are talking about a basically balanced budget (ie very little fiscal stimulus) and monetary policy where interest rates are at the current giddy heights of 22%.

The basic macroeconomic parameters in our forecast are broadly consistent with those of the IMF program. Balance of payments pressures will lead the economy to adjust the composition of growth through 2009. As a result, the current account deficit is expected to improve from over 6 percent of GDP in 2008 to 1-2 percent of GDP in 2009-11. To achieve this adjustment, an over 20 percent real import contraction will be needed in 2009 in order to counter the 7 percent forecast terms of trade deterioration. Real wages and employment are forecast to decline in 2009 to restore price competitiveness of Ukrainian exports in the wake of declining export prices and to support the adjustment in aggregate demand. With this current account adjustment and with the support of the IMF Stand-By, the external financing gap would be closed under our baseline assumptions. Declining commodity prices, tightening liquidity and the forecast decline in domestic demand will contribute to disinflation. However, offsetting this, the exchange rate correction and the adjustment of energy and utilities tariffs will make disinflation a more prolonged process. We assume that the government will maintain a balanced budget in 2009 (not accounting for bank recapitalization costs) and have a small deficit thereafter.

So I think we need to be very clear at this point. The Ukraine position is very difficult, and everything is very delicate. The danger of total financial meltdown (which would be in this case in the private banking sector, not sovereign debt) is real and significant. The economic downturn has only just started and further downside risks are large and depend critically on the size of external shocks and the limitations imposed by inadequate policy responses.

Any further deterioration in the terms of trade (unlikely at this point given how far steel prices have already fallen, but these prices may stay lower for longer than many in the sector can sustain) or further decline in export demand would certainly put almost unsustainable pressure on the real sector. Banking sector vulnerabilities may be further exacerbated by further overshooting of the exchange rate and external debt refinancing difficulties as corporate balance sheets weaken further and household incomes come under strain from rising debt service costs.

Prudent fiscal, monetary, and financial policies (many of them anchored in the program supported by the IMF), accompanied with renewed efforts to deepen structural reforms, can help Ukraine to stabilize its situation and move the economy towards recovery. Conversely, a continuation of the current disorderly response and poor implementation of the agrred policies may easily trigger further financial chaos leading to an even shaper downturn and a postponement of any recovery off into the distant sunset.

But Beyond The Recovery, What About The Demography?One of the reasons why I think the IMF and the World Bank are taking such a big risk with their credibility in Eastern Europe at the moment, is that I don't think they are getting through to the heart of the problem. One way of thinking about this is to take Paul Krugman's favourite Keynes quote - "we've got magneto trouble" - and ask ourselves whether all we have before us in the CEE countires right now are magneto problems, or whether, to continue with the metaphor, we may not have issues with the cylinder head gasket. And it gets worse, because the cylinder head gasket does seem to have blown (and it will keep blowing) because we have leakage problems in the sump, and the main oil pump isn't working - and who knows, maybe the crankshaft even needs replacing. As they always tell you when you take the car into a garage for "fixing", we won't know till we take the thing apart. What do I mean?

Well take a look at the chart showing the relative size of annual births and deaths in Ukraine over the last twenty years.

I mean to the normal and untrained eye stands the problem stands out a mile, population dynamics went underwater in the Ukraine in the early 1990s, and they aren't coming back to the surface again (not now, not in thirty years, not...... well maybe never is too much of a long time, but certainly not over a time horizon which is going to make any essential difference to anyone who is already alive today.)

And this is without taking any outward labour migration into account, so just think about the negative labour market dynamics that this implies, and already has implied. Can anyone really be surprised that Ukraine has been suffering from acute inflation as its number one problem?

To some extent it is worth stressing here that what really matters is the actual numbers of annual live births, rather than any more complex measure of fertility. In 1989 for example there were nearly 700,000 children born in Ukraine. By 1998 this number was near to 400,000 (ie there was a drop of 40% or so in a decade). In practical terms (and if we take 18 as an average age for labour market entry in a country like Ukraine) next year there are potentially 650,000 people to enter the labour force, but by 2016 this number will be only 400,000. So it isn't simply a question of pushing the fertility rate up towards the replacement rate (a difficult, but not impossible task), we also need to think about what economists term the "base effect" here, that is that with each passing year and cohort you have less and less women in the childbearing ages, so even if those women replace themselves, the base of the pyramid is still much narrower than the top, and it is the people at the top who need caring for and financing.

And even if some of this loss can be offset at the workforce level by increasing labour force participation at the older ages, we would still be talking about a very sharp rise in the average age of the workforce. And productivity improvement alone cannot possibly hope to compensate for the kind of labour force contraction we should reasonably expect, at least not over such a short period of time it can't. So this is just one more reason why, against all expectation, fertility really does matter.

While many continue to believe that falling populations don't actually have any tangible impact on economic performance, it is very striking to notice that when it comes to ageing and declining populations we really lack ANY evidence to substantiate that claim in the affirmative. On the other hand we do have plenty of evidence from countries where the population is either falling or gathering negative momentum to suggest that these countries face some very special kinds of economic problems. The example of Eastern Europe is clear enough I would have thought, but people really do need to take a closer look at what has been happening in recent years in countries like Japan, Germany, Italy and Portugal. And if falling population does produce its own kind of economic problems, well then we should be expecting to see plenty of them in Ukraine, since as we can see in the chart below Ukraine's population peaked in 1993, and has been in some sort of free-fall ever since.

Evidently there are a number of factors which lie behind this dramatic decline in the Ukrainian population, fertility is just one of these (with poor health and net emigration being the others). Ukraine fertility is currently in the 1.1 to 1.2 Tfr range, and, as we can see in the chart below, it actually dropped below the 2.1 replacement level back in the 1980s.

Another major influence on demographic dynamics is health, and one good measure of this is the level of life expectancy, which in the Ukraine case has shown a most preoccupying evolution, since it has been falling rather than rising. The chart below shows life expectancy at birth for both men and women, the male life expectancy is evidently significantly below the combined figure.

This life expectancy situation is, as well as being preoccupying, highly unusual (it is however paralleled to some extent in Russia itself, and some other CIS countries). Apart from the obvious, the deteriorating health outlook which this data reflect places considerable constraints on the ability of a society like Ukraine to increase labour force participation rates in the older age groups, and this is a big problem since this is normally though to be one of the princple ways of compensating for a shortage of people in the younger age groups.

So what about the future? Well, two issues are really starting to worry me at present, the first of these is the short term fertility shock Ukraine will undoubtedly receive on the back of the current crisis. If young people were already rather reluctant to have children, then then will now almost certainly be much more so, given the downward pressure on living standards we are about to see.

The second worry concerns the future of the country itself. A recent study carried out jointly by the Kiev based Democratic Initiatives Foundation and Nova Doba History and Social Sciences Teachers Association found that while more than 93 percent of the Ukrainian seventeen year olds they inteviewed considered themselves Ukraine citizens, only 45 percent said they planned to live and work only in Ukraine, citing Western Europe, Russia and the United States as possible future destinations. When 55% of your potential future labour force are thinking of working elsewhere you have a problem, and one which needs a solution. Simply putting a strip of band-aid over a festering wound won't work, I'm afraid, however much the Ukrainian people may struggle and sacrifice. With or without Keynes, we've got more than magneto problems on our hands here.

Postcript

A much fuller analysis of the problems presented by Ukraine's long term population implosion (including the issue of out-migration patterns and trends) can be found in this post here.

Monday, December 22, 2008

With the US Federal Reserve now adopting what is widely regarded as some variant of quantitative easing (QE), and with the Bank of Japan cutting interest rates amidst economic conditions which BoJ Governor Masaaki Shirakawa describes as "severe", perhaps it is worth taking time out to have a looking at some of the earlier experience of quantitative easing in Japan, in order to ask ourselves why it is that central banks may favour this particular approach this time round, and why it is that with monetary policy at very low levels in a number of countries we are not seeing a simple knee-jerk return to/introduction of some form of Zero Interest Rate Policy (ZIRP). In order to answer such questions we will also need to look at the (none to evident) issue of whether or not it is the case that last week's decisions at the BoJ to all effect and purpose do actually constitute a return to QE.

To anticipate a little bit what will be argued in this rather lengthy post, there is a fundamental difference between the recent move towards QE taken by the Fed (especially after the end of September as explained by James Hamilton in this excellent post), and the policy pursued by the BoJ between 2001 and 2006, and this difference concerns the objectives of the policy. While both initiatives have in common that they are strategies to get that "something extra" out of monetary policy in a very low interest rate environment (near the so-called zero bound), they differ in that the Fed's current objective is to provoke a recovery in economic activity in the US, whereas the BoJ had the objective of provoking a sustained rate of inflation above zero. Obviously the two processes - provoking growth and provoking inflation - are related, but there are also subtle differences in the way the respective banks attempt to achieve these objectives. The Fed is concerned about the liquidity question as part of an ongoing attempt to ease a credit crunch, which it is trying to do by bringing yield spreads (and in particular the so called TED spread) down. No one doubts that once this objective is achieved the Fed will rapidly wind down its balance sheet just as rapidly as it wound it up at the end of September. The BoJ, on the other hand, was concerned to convince market participants that the excess balances would be maintained for a long time interval, beyond the point where the price index simply indicated it might move into positive territory. The BoJ had to convince market participants that they were serious about provoking inflation (that is, what they were really targetting weren't bank reserve balances as such, since they were simply using the levels of these balances as an indirect tool for influencing inflation expectations) while the Fed (at this point at least, of course on a worst case scenario of outright deflation in the US, I am sure Bernanke has a Japan-style "plan b" up his sleeve) currently has no inflation target beyond its general objective of price stability and is not trying to steer inflation expectations upwards. Not yet, anyway. And with that caveat......

The BoJ Cuts Rates, But Not To Zero

So if the Fed isn't exactly applying the BoJ 2001-2006 playbook at the present time, what about the BoJ, is it applying some kind of Bernanke style markII QE, and expanding its balance with the objective of easing the credit crunch? Well, this is a much more plausible interpretation of what is happening, and in some senses the earlier BoJ move (in October) in lowering interest rates from 0.5% to 0.3% could be thought of as some kind of initial step towards the reintroduction of some kind of QE in Japan, while last Friday's cut in the BOJ key policy rate to 0.10 percent (when taken together with the commitment to expand the balance sheet, increase its purchase of JGBs and begin outright purchases of commercial paper) really represents its de-facto initiation , despite the fact that Governor Shirakawa was quick to stress that the bank's decision to cut interest rates and buy more assets did not mark a direct and immediate return to the earlier version of quantitative easing. He was able to say this because the BoJ - despite the evident danger signals - still does not anticipate a return to deflation, and thus is not willing to undertake any commitment to provoke inflation. Of course, they may well be criticised later for not being sufficiently proactive here, just as they were in 1998/1999.

What the BOJ did decide to do was raise the ceiling on the amount of Japanese government bonds it buys each month from 1.2 trillion yen to 1.4 trillion (a 17% increase), as well as committing itself to the purchase a of wider range of bonds, and expanding the range of eligible JGBs to include 30-year bonds, floating rate bonds and inflation-indexed bonds.

The Bank also decided to temporarily buy commercial paper outright, following in the footsteps of the U.S. Federal Reserve, despite the strong reservations which have been expressed by a number of BOJ officials in the past about accepting such assets with credit risk. In fact the Bank of Japan has long accepted commercial paper as collateral in its fund operations (and indeed such purchases were an important ingredient in the earlier QE experiment) but has up to now resisted calls to purchase them directly from issuers. The terms and conditions for such purchases still have to be decided, while Governor Shirakawa is still voicing his doubts, so in its press release the BoJ simply stated that all that it had done at this point was undertake to examine the range of corporate instruments and the degree of risk taking that are appropriate for the BoJ.

Thus the BoJ has obviously taken an important step, and is clearly open to the idea that such purchases could be a major instrument in monetary policy. We will obviously need to see more of the details, and some indication of the size of the CP-programme before we can be clearer about how aggressively the BoJ intends to proceed with the initiative at this point, although evidently, once the door is open the measures can obviously be expanded as the situation evolves.

What we can say with rather more conviction is that BoJ policy at this point seems to be oriented more towards the spread between three-month JGBs and the three-month interbank offered rate, Tibor, which rose to its highest level in a decade(0.922%) on December 16 before falling three straight days to hit 0.905% at the Friday fixing. The difference between what the government and Japan’s banks pay to borrow for three months, the so-called TED spread, was running at 46 basis points in mid-week, and this compares with an average of 16 basis points for 2007.

Fiscal And Monetary Tandem

To some extent fiscal and monetary policy is moving in tandem in Japan at the present time (as it is in the US) and the Japanese government also announced last week that it was going to purchase commercial paper, saying that it would buy as much as 20 trillion yen worth of shares held by banks in order to to boost their capital. The measure formed part of an emergency stimulus package worth 43 trillion yen ($489 billion). Thus nearly half of the package will be for purchasing commercial banks' equity holdings as part of efforts to improve the lenders' liquidity, according to the Nikkei business daily.

Evidently if such measures are approved by the Japanese parliament they will push spending to even higher levels. The Finance Ministry's draft budget suggested a spending increase of 6.6 percent to 88.5 trillion yen ($990.9 billion) for the next fiscal year — the biggest ever figure in an initial proposal. The budget proposal expects general spending to rise to 51.7 trillion yen ($578.9 billion) in the next fiscal year, even though tax revenue is projected to fall 13.9 percent to 46.1 trillion yen ($516.2 billion). As a result, Japan will see its primary budget deficit jump to more than 13 trillion yen ($145.6 billion) from 5 trillion yen ($56 billion) this year. This will mean bond issuances will need to rise to 33.9 trillion yen - up by 31.3 percent over fiscal 2008 - to cover the revenue shortfall. The expansion means saying an effective goodbye to Japan's governments goal of balancing the budget by 2011. But Prime Minister Taro Aso, whose popularity rating is falling more quickly than the Spanish construction industry, has made it clear he sees no role for fiscal discipline at a time like this.

In the current fiscal year (which ends next March) tax revenues are now expected to fall 7.13 trillion yen short of an initial estimate of 53.55 trillion yen due to slump in corporate tax revenues as the economy has slid into a recession. The bulk of the tax revenue shortfall will be covered by the government issuing deficit-covering bonds in the second supplementary budget that totals 4.8 trillion yen. To fund the economic steps through the extra budget, the government will also issue so-called construction bonds, which are used for specified purposes such as public works, worth 390 billion yen while dipping into reserves set aside in a special account for "zaito" fiscal investment and loan programmes (FILP). Thus spending in fiscal 2009 is expected to rise by 9.4% while revenue is expected to fall by 13.9% with evident consequences for the fiscal deficit and the size of the accumulated government debt.

On 12 December Prime Minister Aso introduced a 23 trillion yen "livelihood protection package". As part of that package there was a 2 trillion yen ($22 billion) CP purchasing allowance and the government instructed the Japan Finance Corporation (JFC) to engage in "crisis respone operations" and help struggling companies. The Development Bank of Japan is to serve as cashier to fund the CP purchases. Japan's 124 commercial lenders had 25.6 trillion yen in stockholdings at the end of March.

Around 1 trillion yen of low-interest financing for medium to large enterprises was also included and this expenditure will be counted as part of the Fiscal Investment and Loan Programme (FILP), and as a result the programme will expand for the first time in ten years. The ruling LDP has also established a new body the Team To Realise Financial and Real Estate Countermeasures, and this body seems to be pressing for the BoJ to commence open market purchases of JGBs and stocks and REITs, with the estabishment of an entity to purchase more than 10 trillion yen of stocks.

Why Not All The Way To Zero?

Certainly in the United States, it increasingly seems that Ben Bernanke has decided to adopt QE rather than a more straightfoward lowering of the federal funds rate directly to zero. Part of the thinking which lay behind this move was explained by Bernanke himself, in a paper he prepared with Vincent R. Reinhart (Director, Division of Monetary Affairs, Federal Reserve Board) back in 2004.

Bernanke and Reinhart give two reasons for not going all the way to zero. Firstly:

Observers have pointed out that rates on financial instruments typically priced below the overnight rate, such as liquid deposits, shares in money market mutual funds, and collateralized borrowings in the "repo" market, would be squeezed toward zero as the policy rate fell, prompting investors to seek alternatives. Short-term dislocations might result, for example, if funds flowed in large amounts from money market mutual funds into bank deposits. In that case, some commercial paper issuers who have traditionally relied on money market mutual funds for financing would have to seek out new sources, while banks would need to find productive uses for the deposit inflows and perhaps face changes in regulatory capital requirements. In addition, liquidity in some markets might be affected; for example, the incentive for reserve managers to trade federal funds diminishes as the overnight rate falls, probably thinning brokering in that market.

and secondly:

"A quite different argument for engaging in alternative monetary policies before lowering the overnight rate all the way to zero is that the public might interpret a zero instrument rate as evidence that the central bank has "run out of ammunition." That is, low rates risk fostering the misimpression that monetary policy is ineffective. As we have stressed, that would indeed be a misimpression, as the central bank has means of providing monetary stimulus other than the conventional measure of lowering the overnight nominal interest rate."

Thus, in the first place distortions occur in the normal functioning of the money markets, while in the second a mis-perception arises (on Bernanke's view) among the public that policy is ineffective and that the central bank can then do nothing. Both these lines of reasoning may help explain why the preferred line of attack at this point is to take rates to a very low level, just above zero, but not all the way to zero.

Quantitative Easing In Japan

Returning for a bit to the Japanese experience of QE in the early years of this century, we find that the Bank of Japan embarked (back in March 2001) on what was then an unprecedented monetary policy experiment. This experiment, which is commonly referred to as "quantitative easing," was an attempt to stimulate a Japanese economy which had become stagnant under the dead weight on continuing ongoing deflation expectations and a monetary policy which seemed to have gotten stuck at what had become known as the "zero bound". The BoJ had come under considerable criticism from a number of academic economists (most notably Ben Bernanke and Paul Krugman, see bibliography below) for failing to respond aggressively enough to the deflation problem in the 1990s.

QE was introduced as a response to what was seen as the failure of earlier monetary policy. As a response to the growing deflation problem following the onset of a sharp recession Japan lowered its overnight call rate from around 0.43% to 0.25% in September 1998. The rate was further lowered to near 0% in March 1999. In April 1999, the BOJ made an initial promise (subsequently seen as inadequate) to maintain a zero interest rate “until deflationary concerns are dispelled” - thus began the so-called zero interest rate policy (ZIRP). Following the application of this policy the Japanese economy appeared to be recovering, although not the price level, since it grew at a 3.3% year on year pace between Q3 1999 and Q3 2000. As a result the BoJ abandoned the ZIRP policy in August 2000, and it was this abandonment which has been the object of so much criticism - especially, and most notably, from Paul Krugman.

The economy, however, rapidly fell back into another serious recession following the global decline in the demand for high-tech goods subsequent to the internet bust. Actually my feeling here is that many of the critics are confusing two (logically, if not always practically) separate issues here, the export dependence of an elderly Japanese economy with insipid domestic demand growth, and the problem of the internal price level, or deflation. The two are obviously inter-related, but not so simply as to say that the Japanese economy fell back into recession due to the 2000 BoJ tightening of monetary policy. Undoubtedly the deflation problem worsened as a result of this policy, but the recession came because Japan was unfortunate enough to apply this policy just as the global economy went south bigtime, and again we can see the same sort of process at work in 2007, since the move of Japan's economy back towards recession is connected with export dependence (which could be to do with the high median age of its population) and not a by-product of the decision to end QE in 2006.

Be all this as it may, as a reaction to the renewed recession the BOJ announced the introduction of the quantitative easing policy in March 2001.

As I say above a key component of QE is the way the central bank handles expectations, and the BOJ initially committed to maintain the policy until the core consumer price index registered "stably" a 0% or a positive increase year on year. This commitment was further modified in October 2003 when the BOJ committed itself to continue providing ample liquidity "until both actual and expected inflation turned positive".

The core of QE was the maintainence of an ample liquidity supply by using the current account balances (CABs) at the BOJ as the operating policy target, with the commitment to maintain ample liquidity provision until the rate of change in the core CPI becomes positive on a sustained basis. Thus the focus of policy becomes not the interest rate itself, but the amount of liquidity as reflected in the current balances. In fact during the ZIRP period, the overnight call rate never actually reached zero, but declined to at most 0.01%, while during the period of QE, the rate further declined to 0.001%.

The BOJ also announced that it was ready to increase the amount of purchases of long-term government bonds in order to meet the target on the CABs. The target on the CABs was raised several times, reaching ¥ 30-35 trillion in January 2004, compared to the baseline required reserves which were running at approximately ¥ 6 trillion. In order to meet such targets the BOJ conducted various purchasing operations including the purchase of bills and commercial paper (CPs) in addition to treasury bills (TBs) and government bonds. After 2003, the BOJ also started buying asset-backed commercial paper (ABCPs) and asset-backed securities (ABSs).

Initially the CAB target was set at ¥ 5 trillion (in March 2001) at a time when the level of CABs was around ¥ 4 trillion, thus the initial diffeence was not that great. By May 2004 the CABs had grown eightfold, with an average annual growth rate of 92%. The principle vehicle of liquidity intervention was the purchase of JGBs and during the same period the BoJ purchased ¥ 37.8 trillion in Japan government bonds. The amount of monthly purchases of JGBs has been set and pre-announced by the BOJ. This amount was equivalent to 0.4 trillion yen per month in March 2001 and was gradually increased to 1.2 trillion yen by May 2004. As a result of these policies Japan's monetary base grew by 67% over the same period.

The three building blocks of Japanese QE were thus ensuring ample liquidity provision, commitment to continue such liquidity provision, and the use of various types of market operations, especially purchasing of long-term government bonds, and in many ways these correspond to the three balance sheet expansion mechanisms identified by Bernanke and Reinhart (2004) whereby a central bank can operate an expansionary monetary policy even at very low interest rates.

However, the two approaches are not identical. The BOJ policy of increasing the CAB target may have had the effect of making the liquidity-providing commitment more credible, and the BOJ’s long-term government bond purchasing operations certainly represented the major tool to meet the target on the CABs. The possibility remains, however, that changes in the composition of the BOJ’s balance sheet caused by its market operations have had some effects on the term structure of interest rates. While there exist differences between the policies these authors propose and those adopted by the BOJ, the basic ideas are the same. Even at a zero short-term interest rate, it is possible to pursue further monetary easing that affects expected future short-term interest rates and thus current long-term interest rates through a commitment to appropriate future monetary policy paths.

The policy was lifted five years later, in March 2006. At the launch of the program, many were skeptical that it would have any impact on the real economy, as overnight interest rates were already close to zero, and thus flooding Japanese commercial banks with excess reserves might only amount to swapoing two assets both of which had close to zero yields. Others had been highly critical of the Bank of Japan in the years prior to the introduction of QE (among others Ben Bernanke himself, see here), in particular for their strong reluctance to engage in open ended "unsterilised" interventions. With the introduction of quantitative easing all of that changed to some considerable extent.

Whether the ZIRP and/or RZIRP have affected expected future short-term interest rates, however, is a more subtle question than it initially appears to be. Even without any commitment by the central bank, the market normally forms expectations about future monetary policy stances, ie the path of short-term interest rates.

The Latest Fed Initiative

The Federal Reserve Open-Market Committee decided this week that it was going to use “all available tools” in an attempt to generate a resumption of GDP growth in the United States. This, and the maintenance of price stability, would seem to be the Fed's principal objectives at the present time, and the effective demotion of the benchmark interest rate as a focus of policy attention (the target for overnight loans between banks will henceforth and until conditions improve be maintained in a range between zero to 0.25 percent) is merely a commitment to maintaining a low interest rate environment while the other tools, the balance sheet enhancing ones, do the actual heavy lifting. Since this rate objective is now not going to change in the foreseeable future (the Fed's commitment is for "as long as it takes"), the focus of attention will turn to the liquidity providing measures which the Fed will adopt and to the TED spread as an indicator of the degree of severity of the credit crunch.

As a consequence the Federal Reserve is now exploring a wide range of possibilities, including open market purchases of lower-rated securities, with backing from the Treasury. The Fed thus looks set to expand its current $600 billion initiative to buy debt issued or backed by the government-chartered mortgage-finance companies - it is alreadt trying to lower mortgage rates via the purchase of up to $100 billion of Fannie Mae and Freddie Mac debt as well as $500 billion of mortgage-backed securities they have guaranteed. It is also “evaluating” purchases of longer-term Treasury securities. It may well also enhance other existing programs which include the purchase of commercial paper from companies and financial firms and a offering a backstop for money-market mutual funds.

Thus composition and size of its balance sheet will now be the Fed’s principal policy focus, and, in a key difference with Japan’s earlier quantitative easing experience, the Fed is targeting specific assets for purchase to lower credit spreads rather than expanding the amount of cash in the banking system per se. In fact the Fed will still work to maintain large quantities of liquidity in the bank reserve balances, but whereas the BoJ principally increased the balances through the purchase of JGBs the Fed is placing much more emphasis on the direct purchase of agency securities, on the acquisition of mortgage-backed securities and on lending money directly to the private sector.

“The focus of the committee’s policy going forward will be to support the functioning of financial markets and stimulate the economy through open market operations and other measures that sustain the size of the Federal Reserve’s balance sheet at a high level,” the FOMC said.

The Fed “will employ all available tools to promote the resumption of sustainable economic growth and to preserve price stability,” the Federal Open Market Committee said today in a statement in Washington. “Weak economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time.”

These moves have already increased the Fed’s balance sheet substantially, and it has risen to a current $2.26 trillion from $868 billion in July 2007. And in addition there is the $700 billion Troubled Asset Relief Program, which the U.S. Treasury has been using since October to channel about $335 billion of capital injections into banks and other financial institutions.

The federal funds target rate has been steadily weakening as a monetary policy tool simply because the flood of funds the Fed has been sending to the markets since late September has meant that the average daily rate (or effective rate) has trade below the actual policy goal rate on every day since Oct. 10. The gap between the target and the effective rate, or average daily market rate, has averaged about a half point since September 12. The gap averaged just above zero from the start of this year up to September 12. This state of affairs is thus not that dis-similar from the Japanese situation in 1998/99, since at that point the actual Japanese overnight market rate was systematically trading below its overnight target and a reluctant BoJ was eventually forced to cut its target rate in two small steps.

So is this quantitative easing? Well the Fed statement said simply that it would be using its balance sheet to support credit markets and the economy, however a senior Fed explained to the somewhat bemused journalists that the bank's approach is seen as being distinct from quantitative easing as practised by the Japanese. The official pointed out that Fed's balance sheet has two sides: assets with securities the Fed holds (including loans, credit facilities, mortgage-backed securities) and liabilities (cash and bank reserves). Japan's quantitative easing program focused on the liability side, expanding cash in the system and excess reserves by a large amount. The Fed's focus, however, is on the asset side through mortgage-backed securities, agency debt, the commercial paper program, the loan auctions and swaps with foreign central banks. This securities-lending approach is intended to directly affects credit spreads, which is where the Fed perceives the problem to be today.

The Fed official stressed in his explanation that the Fed does not expect deflation, but expects inflation to fall.

Quantitative Easing Or Not Quantitative Easing?

So do we or don't we have quantitative easing in Japan? Well my opinion is that the BoJ has effectively turned to some kind of quantitative easing regime, despite protests to the contrary from Governor Shirakawa at the BoJ post meeting press briefing. But this version of QE is different from the previous one, since the BoJ is not targeting inflation expectations at this point. Governor Shirakawa has argued strongly for keeping short-term money market interest rates slightly positive to improve the functioning of the money market, so it is unlikely the BoJ will move to further reduce the overnight target rate. What I do think we will see, however, is more moves to expand the BoJ's balance sheet, focussing initially the asset side and on the three-month Tibor rate spread with three-month JGBs - purchasing ever increasing quantities of government debt, followed by a subtle shift over to emphasising the liabilities side of the balance sheet, and the size of current balances as deflation locks in and the bank once more attempts to "steer" expectations about the price level.

To try to help us understand where we are, and where we aren't here, below I am reproducing a selection of Sirakawa's comments in the press conference which followed the rate setting meeting.

Shirakawa's Comments After The Announcement

"In broad terms, Japanese interest rates are already close to zero. The last time the BOJ adopted quantitative easing, it aggressively supplied cash to markets to push down rates to zero. In that sense, we haven't adopted quantitative easing or a zero rate policy ...

"It was a decision reached after a comprehensive assessment on how to stimulate the economy and also pay heed to market functions."

"Of course, we can't say we will never opt for a certain monetary policy step in the future. This time we cut the call rate target but left the interest we pay to excess reserves parked at the BOJ at 0.1 percent, after much debate about how to maintain money market functions ...

"We cut rates to 0.1 percent and decided to buy various assets, but these measures are not aimed at expanding the BOJ's balance sheet. We will of course aim to stabilise financial markets and support corporate financing. We are taking measures for these purposes, not to expand our balance sheet."

(Asked about the effect of the BOJ's past experience of pledging to keep monetary conditions easy until consumer inflation emerged, or so-called 'policy duration effect')

"Pledging to maintain low interest rates even when the economy was recovering had a certain effect in pushing down long-term interest rates ... When the economy is in bad shape, no one believes the central bank will raise rates so the impact of the commitment is not big."

"We've raised JGB buying by 200 billion yen in the past. So I think it was a natural increment........We'll start buying long bonds and we'll start buying based on maturity ... Long bonds will remain on our balance sheet for a long time. But we judged that our holding of JGBs will remain below the amount of notes in circulation even after the increase.......I'm not planning to increase the amount of JGB buying further for the time being......Regarding the question of whether we are aiming at bringing down long-term interest rates, the increase in the purchase of long-term bonds is not aimed at that.

"This is about money market operations, not about lowering long-term interest rates......It is aimed at avoiding a distortion of money markets that could occur by relying too much on short-term market operations in providing long-term funds......The increase could affect the demand-supply balance of a certain sector of JGBs as a result. But we are not aiming to reducing risk premium (on long-term bonds)."

"The last time Japan adopted quantitative easing, it was a policy aimed at stimulating the economy through massive liquidity supply by targeting the amount of current account reserves at the BOJ. In this sense, both the United States and Japan have not adopted quantitative easing.

"Of course, we continue to provide liquidity actively to maintain financial market stability and smooth corporate financing. The current account balance could increase as a result of measures to stabilise the financial market and banking system, but that has a somewhat different meaning than last time ...

"Given our experience in the past, we can say that increasing the amount of money was effective in stabilising the financial system. As for its impact on the economy and prices, I'm not saying it didn't have an effect at all. But it was hard to find a clear effect.......It's hard to say anything about the future because members of the policy board could change by then ... Still, no one on the BOJ board seems to think that boosting base money would stimulate the economy."

"Every board member agreed that economic conditions are very severe. We want to stimulate the economy through interest rates but given that rates were already at 0.30 percent so there was limited room for cuts. ......And we wanted to keep the functioning of money markets. We didn't want it to weaken because of our policy.....By cutting interest rates to 0.10 percent, some of the function of money markets may be hampered. But by maintaining positive interest rates, there will remain incentives for trade and the bedrock for financial activity."

Well, there certainly do seem to be a lot of subtleties and nuanceshere, and a lot market observers may well have real difficulties in understanding what he is trying to say, although I do hope that after reading this post, many of my readers may not now be labouring under that difficulty (it certainly took me some time to get through to what was actually going on). In this sense Shirakawa might do well to reflect on this key point in Bernanke and Reinhardt:

"Note that the expectational and fiscal channels of quantitative easing, though not the portfolio substitution channel, require the central bank to make a credible commitment to not reverse its open-market operations, at least until certain conditions are met. Thus, this approach also poses communication challenges for monetary policy makers."

The Fed does seem in this sense to have been somewhat clearer:

"The Federal Reserve will employ all available tools to promote the resumption of sustainable economic growth and to preserve price stability. In particular, the Committee anticipates that weak economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time. "

Did Quantitative Easing As Tool For Monetary Policy Caught In A Liquidity Trap Actually Work In Japan?

Well, this is the three trillion yen question isn't it. Certainly there is no consensus that this policy, rather than the sudden sharp rise in global commodity prices, was what dragged Japanese headline CPI numbers kicking and screaming out of years of deflation, nor is it clear that the termination of this policy, rather than the global trade slump which has followed the credit crunch, is what is sucking the Japanese CPI back below zero. There is little strong evidence on either side about the precise impact of QE on the price level, and certainly any effect there may be is small. Perhaps the best that can be said is that this policy helped avoid a worse outcome, with Japanese prices sinking ever deeper into deflation.

But it does now seem that back we jolly well go, since Japanese core annual inflation slowed in October for a second straight month, raising concerns that the sharp negative energy price shock heightens the risk of a return to deflation as we enter 2009. The core consumer index - which excludes volatile prices of fresh fruit, vegetables and seafood but includes the cost of oil products that are falling rapidly in price - rose 1.9 percent in October from a year earlier, slipping back from the 2.3 percent increase in September. Annual inflation excluding oil products dipped to 1.2 percent while Tokyo figures for November point to further falls in inflation.

If we look at what is known as the "core-core" index (which strips out both energy and fresh food) then we can see that it is far from clear that Japan ever really escaped from the deflation trap, since this reading has been completely flatlining around (and normally slighly below) zero over the last twelve months, and with a very large capacity overhang now developing, this index will almost certainly get back into negative territory very, very soon.

Appendix: Why Japan And The United States Are Different

Finally, should we anticipate a Japanese "outcome" in the United States. I think not. The US economy may well have a brush with deflation in 2009, and monetary policy may not be as effective as Bernanke hopes in avoiding this, but equally the US economy is unlikely to get stuck in deflation in the same way that Japan has (which isn't the same thing as saying we may not see a protracted slowdown in headline US GDP growth) since Japan's ongoing deflation issue is structural, and associated with the country's underlying demographic dynamics. As an illustration of this, I am reproducing here in the form of an appendix some excerpts from one of Paul Krugman's more widely read analytical papers on the Japan problem - It's Baaack! Japan's Slump And The Return Of The Liquidity Trap. Obviously this extract doesn't "establish" anything, but it does provide an illustration of one possible way of looking at the Japan question, and does suggest (since US demographics are very, very different) one good reason for not anticipating a Japan outcome in the US.

One way of stating the liquidity trap problem is to say that it occurs when the equilibrium real interest rate, the rate at which savings and investment would be equal at potential output, is negative. An immediate question is therefore how this can happen in an economy which is not the simple endowment economy described above, but one in which productive investment can take place - and in which the marginal product of capital, while it can be low, can hardly be negative. An answer that may be extremely important in practice is the existence of an equity premium. If the equity premium is as high as the historic U.S. average, the economy could find itself in a liquidity trap even if the rate of return on physical capital is as high as 5 or 6 percent. A further answer is that the rate of return on investment depends not only on the ratio of capital's marginal product to its price, but also on the expected rate of change of that price. An economy in which Tobin's q is expected to decline could offer investors a negative real rate of return despite having a positive marginal product of capital. This point is actually easiest to make if we consider an economy, not with capital, but with land (which can serve as a sort of metaphor for durable capital) - and also if we temporarily depart from the basic setup to consider an overlapping-generations setup, in which each generation works only in its first period of life but consumes only in its second. Let A be the stock of land, and Lt be the labor force in period t - that is, the number of individuals born in that period. Given the special assumption that the young do not consume during their working years, but use all their income to buy land from the old, we have a very simple determination of qt, the price of land in terms of output: it must simply be true that

qt.At = wt.Lt

where wt is the marginal product of labor. So in this special setup q itself is not a forward-looking variable; it depends only on the size of the current labor force. However, the expected rate of return on purchases of land is forward-looking. Let Rt be the marginal product of land, and rt the rate of return for the current younger generation. Then we have that:

1 + rt = Rt+1 + qt+1 /qt

Now suppose that demographers project that the next generation will be smaller than the current one, so that the labor force and hence (given elastic demand for labor) the real price of land will decline. Then even though land has a positive marginal product, the expected return from investing in it can in principle be negative. This is a highly stylized example, which begs many questions. However, it at least establishes the principle that a liquidity trap can occur despite the existence of productive investment projects.

In fact, this exercise suggests that the real puzzle is not why Japan is now in a liquidity trap, but why this trap did not materialize sooner. How was Japan able to invest so much, at relatively high real interest rates, before the 1990s? The most obvious answer is some version of the accelerator: investment demand was high because of Japan's sustained high growth rate, and therefore ultimately because of that high rate of potential output growth. In that case the slump in investment demand in the 1990s may be explained in part by a slowdown in the underlying sources of Japanese potential growth, and especially in prospective potential growth.

As noted above, there is considerable uncertainty about the actual rate of Japanese potential growth in the 1990s. Nonetheless, it is likely that there has been a slowdown in the rate of increase in total factor productivity, even cyclically adjusted. What is certain, however, is that Japan's long-run growth, even at full employment, must slow because of demographics. Through the 1980s Japanese employment expanded at x.x percent annually. However, the working-age population has now peaked: it will decline at x.x percent annually over the next xx years (OECD 1997), and - if demographers' projections about fertility are correct - at a remarkable x.x percent for the xx years thereafter. As suggested by the discussion of investment and q in the first half of this paper, such prospective demographic decline should, other things equal, depress expectations of future q and hence also depress current investment.

Of course, the looming shortage of working-age Japanese has been visible for a long time; indeed, the budgetary consequences of an aging population have been a preoccupation of the Ministry of Finance, and an important factor inhibiting expansionary fiscal policy. Why, then, didn't this prospect start to affect long-term investment projects in the 1980s? One answer is that businesses may have believed that total factor productivity would grow rapidly enough to make up for a declining work force. However, the "bubble economy" of the late 1980s may also have masked the underlying decline in investment opportunities, and hence delayed the day of reckoning.

Tuesday, December 16, 2008

Russia's foreign-exchange reserves have been now been declining very rapidly since mid August, and as the money goes so does the faith that the large stock of reserves the country built up during the boom times would be sufficient to see them through any downturn in energy prices. As the money leaves, so it seems does the decade of economic growth and stability which they symbolised. Indeed so rapid has been the decline that Russia's international reserves, which are the third-biggest after those of China and Japan, have now fallen $161 billion, or 27% percent, since 8 August last, and decreased by $17.9 billion to $437 billion in the week to 5 December. Investors have now pulled $211 billion out of the country since August, according to estimates by BNP Paribas.

But just how difficult managing this process is proving to be was illustrated yet again this morning as Russia’s central bank found itself forced to accept a further devaluation in the ruble - for what is now the second time in a only a week - subsequent to which the ruble fell as much as 1.3 percent (to a four-year low of 37.5015 per euro) as Bank Rossii widened the trading band against the basket of dollars and euros used by the bank as the measure for attempting to manage the exchange rate.

Russia has now used some 27 percent of its reserves in these attempts to stem what has now become a 16 percent decline in the ruble following a 69 percent drop in the price of oil and last weeks decision by credit ratings agency Standard & Poor’s to cut its Russian credit rating on for the first time in nine years.

Thus over at Bank Rossii they have been having their work cut out "fexibilising" the trading band, and it this flexibilisation process that has now allowed the ruble to fall against its target exchange rate against a basket of currencies by 8.6 percent, down further from the 7.7 percent level facilitated last week and the 3.7 percent one of a month ago. Thus the currency has now fallen a net total of 5.9 percent against the basket in the series of six "adjustments" to the trading band implemented since 11 November. However this "slow and steady" approach to devaluation is creating uncertainty, as well as fomenting a loss of confidence with Russians withdrwaing a total of 6 percent from their ruble accounts in October alone, the fastest rate of withdrawal since Bank Rossii started collecting this data two years ago, while foreign currency deposits rose 11 percent. Thus instead of reinforcing confidence in the monetary regime, the slow, step-by-step adjustment of the nominal exchange rate may be perpetuating a steady stream of deposit withdrawals and dollar purchases, and some evidence for this can be found in November's 5.9 percent contraction in the money supply.

Apart from the financial turmoil, Russia's economy is really reeling under the weight of the sharp drop in crude prices, and the price of Urals crude, Russia's main export blend, is currently trading at around $44.13 a barrel, down 69 percent from the July peak, and well below the $70 average required to balance the country's 2009 budget.

GDP Growth Slowing Rapidly

It is hard to get a fix at the present time on what Russia's growth rate will look like in 2009, and estimates vary widely. Deutsche Bank recently cut its Russian growth forecast to 1 percent for next year, down from an earlier 3.4 percent, while the World Bank last month forceast a slowdown to 3 percent from what has been an average expansion of 7 percent a year since 1999. At the bottom end of the forecast range we have Oleg Vyugin, chairman of MDM Bank and a former central banker, who suggests the economy may contract by as much as 4% if the prices of raw materials exports do not recover. My own feeling is that the final figure may well be much nearer to Vyugin's estimate than to the World Bank one, especially if we don't get a strong rebound in commodity prices and given the sharp contraction in non-energy industrial output.

Analysts an OAO Sperbank have gone one step further and come up with two possible scenarios for possible impacts of the economic slump on property prices. For the first (or mild case) scenario they postulate a 2.5-3.5% growth in GDP, 11% inflation and a 30 ruble per dollar exchange rate in 2009. In this case, the bank anticipates a drop in Moscow real estate prices of 34.4% in ruble terms and 46.6% in dollars. On the second scenario GDP stagnates (or even contracts by up to 2.5%), there is higher inflation and an even larger devaluation of the ruble against the dollar. On this (worst) case scenario the Bank suggests that Moscow property prices would plummet by 38.1% in rubles and 59.6% in US dollars. You have been warned!

The Inflation Worm Is At The Heart Of The Problem

The real difficulty facing Russia's macroeconomic managers is that after two years of shocking inflation domestic industry is in no position to compete with its overseas competitors while the ruble remains at its present rate, while any sharp devaluation will have a serious impact on the balance sheets of those who took advantage of cheaper interest rates available abroad to do their borrowing using forex loans. This situation is not that different from that which is to be found in many other economies across the region, in Latvia, Hungary, Ukraine and Romania (for example), with the added rider that the IMF representatives who are in dialogue with policy makers in these very fragile economies would do well to bear in mind the potential knock-on effect of any coming downward adjustment in the ruble.

In annual terms inflation is now slowing, and was down to 13.8% in November, from 14.2% in October. Still, these are very - unacceptably - high numbers, and those who so willingly acquiesced in them earlier will now feel the downside of their negligence, although unfortunately it is - as ever - the poor old Russian in the street who will really pick up the bill.

Basically, the credit driven consumer boom which accompanied the commodities one severely distorted the always delicate balance between Russia's commodities and manufacturing sectors, leaving the manufacturing sector strongly uncompetitive. It is this lack of competitiveness which now exaccerbates the severity of the downturn, just as many commentators, including yours truly, where arguing it would do. Frank Gill from Standard and Poor's puts it like this.

Accompanied by generous government spending, the credit boom also fueled inflation, which weighed on the competitiveness of Russia's noncommodity sector. As wage growth averaged nearly 30 percent over the last two years and the ruble-denominated cost of production rose, domestic manufacturers found it very difficult to compete with cheap high-quality imports. As a consequence, entrepreneurs logically avoided manufacturing and, instead, invested in much more profitable and more import-intensive sectors, such as banking, retail and construction.

The resulting structural imbalances were well camouflaged by the extraordinary growth in energy and other commodity prices. For six straight years, the earnings from Russian oil and commodity exports on world markets have increased much faster than the cost of imports, offsetting the less flattering volume effects. From 2003 through this year, the cumulative difference between export and import price inflation in Russia was a fairly remarkable 74 percent. This put upward pressure on the ruble, encouraging borrowers to take loans in dollars or euros at negative real interest rates, under the assumption that the ruble would appreciate indefinitely. But it also provided an important source of financing.Frank Gill, director of European sovereign ratings at Standard & Poor's in London, writing in the Moscow Times

The critical part of the overheating process was to be found in the evolution of real wages which continuously outpaced productivity growth, thus undermining competitiveness. According to Rosstat, average real wage growth in the first nine months of 2008 was 12.8 percent, down from 16.2 percent during the same period in 2007 (see chart below). Meanwhile unemployment has continued to decline, and reached 5.3 percent in the third quarter, suggesting that at that point the economic slowdown had still not reached the labour market. But this is expected to change quite dramatically now, as the credit seize up and construction slump lead to lay offs in one enterprise after another.

The Russian government has implemented a programme - worth about $200 billion - involving a mixture of loans, tax cuts and other measures to boost liquidity and reduce borrowing costs as the 50-stock RTS Index heads for its worst year since 1998, while the ruble denominated Micex stock index is down 64 percent since 1 August.

``It's a vortex of despair,'' said Julian Rimmer, head of sales trading at UralSib Financial Corp. Russian stocks are weighed down by ``an economy rendered sclerotic by the vanishing of credit, a market paralyzed by margin calls and illiquidity, the opacity of earnings through 2009 and the ruble quivering while speculators circle''.

Finance Minister Alexei Kudrin has said the government has already spent 90 billion rubles ($3.3 billion) out the available total of 175 billion rubles set aside for investing in domestic stocks and bonds. VTB Group (Vnesheconombank), Russia's second-biggest bank, lent 190 billion rubles ($6.9 billion) to companies in November alone as part of the plan following the supply of 120 billion rubles to what Finance Minister Alexei Kudrin termed the "real sector" (or non financial companies) in October.

FDI Drying Up?

Russia's supply of foreign direct investment seems to be steadily drying up. During the first nine montsh of this year the country attracted 2.3 percent less foreign direct investment than it did in the same period in 2007 as the global credit squeeze reduced investor appetite for emerging market projects. Direct investment was running at $19.2 billion over the period, while total foreign investment, including credits and flows into securities markets, was $75.8 billion, a drop of almost 14 percent over 2007, according to the most recent data from the Federal Statistics Service. Foreign investment in stocks and bonds fell 16 percent to $1.3 billion. Foreign direct investment was at a record $27.8 billion in 2007, up 100% over 2006, and thus the fall has not been that dramatic, so far, but the numbers for the last quarter will undoubtedly be much worse than those for the earlier part of the year.

S&P Downgrade

Russia’s long-term debt rating was lowered earlier this month - for the first time in nine years -by ratings agency Standard & Poor’s, who cited capital outflows and the “rapid depletion” of the foreign currency reserves as their justification. Russia's rating was cut one level to BBB, the second-lowest investment grade, and down from BBB+. The last time S&P downgraded Russia was in January 1999, when the country had a rating of SD (or ‘selective default’) following the government's decision to default on $40 billion of debt. Russia’s outlook remains “negative.”

“The rapid depletion of reserves in order to resist a more substantive adjustment of the nominal exchange rate increases the chances of discontinuous exchange-rate movements later, at a lower level of international reserves, with even more severe consequences for the private sector,” said Frank Gill, S&P’s primary credit analyst in London, in the statement.

S&P said it expected Russia’s current-account surplus to swing into a deficit equivalent to 2.6 percent of gross domestic product next year, compared with a surplus of 5 percent in 2008 due to a “sharp deterioration in the country’s terms of trade”. Russia’s GDP growth is expected to decline “sharply” in 2009, according to the agency.

Energy, including crude oil and natural gas, accounted for 73 percent of exports to countries outside of the former Soviet Union (not counting the three Baltic states), in the first 10 months of this year, according to data from the Federal Customs Service, while the federal budget is likely to “shift into deficit” as the government implements emergency tax cuts, commodities prices remain low, and a weaker economy generates less tax revenue, according to S&P. Russia’s budget surplus amounted to 7.8 percent of GDP in the first 10 months, according to Finance Ministry data, but so sharp is the turnaround that Russia may need to use most, or even all, of the money in its two oil funds to cover the budget deficit and recapitalize banks should oil prices stay at about current levels. These funds - the National Wellbeing Fund and the Reserve Fund - held a combined $209 billion as of 1 December.

Moody’s Investors Service also changed Russia’s rating outlook at the end of November - to stable from positive - citing their opinion that the defense of the exchange rate has been "ineffective and extremely costly for official reserves".

“Russia is now facing a perfect storm of falling commodity prices, weaker external demand, tighter credit conditions and slower real incomes growth for which no amount of currency adjustment can compensate,” Neil Shearing, an emerging-markets economist at Capital Economics Ltd. in London, said in a research note today.

Russia's response to the crisis seems to be what might be termed a "process in development", with new measures being continuously announced. In one of the latest such "developments" Finance Minister Alexei Kudrin said the government is thinking of using some of the funding to buy bank mortgages and will also provide 300 billion rubles ($11 billion) to guarantee corporate loans in a bid to boost liquidity. “In order to strengthen guarantees for loans, including loans for two and three years, the state must be ready to provide 300 billion rubles,” Kudrin said in a televised broadcast on the Russian state channel Vesti-24. “If necessary we can increase this limit.” Thirty billion rubles in loans are also to be provided to large airlines like Aeroflot and Transaero, according to First Deputy Prime Minister Igor Shuvalov, while Vnesheconombank, Russia’s state-run development bank, has now requested a total of 950 billion rubles ($34 billion) in government funds. To put all this in perspective, the latest amount requested by VEB represents more than 7.5 percent of Russia’s foreign-currency reserves.

Services And Manufacturing Contraction

Russia's real economy is shrinking very rapidly under the weight of all this. Russian service industries shrank in November at the fastest rate on record, and the VTB Bank Europe Services Sector Purchasing Managers’ Index was in contraction mode for a second consecutive month (registering 37.2, a sharp acceleration in the rate of contraction from the 47.4 reading in October). On such indexes a reading of 50 is the dividing line between expansion and contraction. The contraction in service industries was “by far” the biggest since the survey began in October 2001, according to the VTB statement. “Activity, new business, employment and backlogs all registered much steeper contractions than in October.”

VTB Group’s Manufacturing Purchasing Managers’ Index also showed a decline in November, this time for the fourth consecutive month, and the index registered a record low of 39.8, even lower than that of September 1998, when Russia defaulted on $40 billion of domestic debt and sharply devalued the ruble.

The manufacturing reading is also confirmed to some extent by the November industrial output data from Rostat, since output contracted year on year by 8.7 percent after a 0.6 percent rise in October. Production shrank for the first time since new methodology was introduced in 2003 and, again, this was the biggest decline since 1998. Manufacturing fell an annual 10.3 percent compared with growth of 0.3 percent in October. Steel pipe production dropped an annual 36.9 percent and coking coal output fell 38.7 percent. Truck and car production dropped 58.1 percent and 7.2 percent respectively. Russia’s largest steelmaker, OAO Severstal, have announced they are cutting output by half and plan to reduce spending 20 percent in 2009, while Ford Motor announced on 8 December it was closing its St. Petersburg factory between 24 December and 21 January.

Is Russia On The Brink Of Outright Recession?

Russia may well already be in its first recession since 1998, according to what may well have been a slip of the tongue by Deputy Economy Minister Andrei Klepach while Evgeny Gavrilenkov, chief economist at Troika Dialog, estimates that the word's largest energy exporter may already be running a current account deficit.

“The recession has already begun and, I’m afraid, it won’t end in two quarters,” Klepach said in comments made in Moscow today that were confirmed by his press secretary.

Klepach added that the economy would grow by less than the ministry’s current forecast of 6.8 percent for 2008, and that industrial output growth will slow to around 1.9 percent for the whole year.

Gross domestic product growth dropped to 6.2 percent in the third quarter, and this was already the slowest pace in three years. Russia’s last economy fell into recession in the first quarter of 1998, and only returned to growth in the second quarter of 1999. Growth has averaged over 7 percent a year since 2000.

As I said, Klepach's declaration may well have been a (Freudian?) slip of the tongue (or tongue twister) since he later qualified his statement, saying there had been some linguistic confusion given that the Russian words “retsessiya” (recession) and “spad” (decline, slump) “mean the same thing". "This isn’t a technical recession in the American sense.” he said - referring to the fact that a recession is often defined as two consecutive quarters of negative growth. Actually the sticklers among us will note that the two quarters negative growth rule of thumb is not in fact the US criterion (since the NBER business cycle dating committee use their own "in house" methodology, as I explain in applying this methodology to Spain here), but he may be right, and what we have on our hands may best be termed a "slump" rather than a recession, but which ever it is, of one thing I am sure: the contraction has already started.

Whatever the confusion, what Klepach did make clear is that he expected Russia’s economy to grow by only 2.6 percent year-on-year in the fourth quarter (giving total growth for the year of 6 percent) and this does seem to suggest that the economy is already contracting on a quarter on quarter basis.

Equally worrying is the evolution in the current account deficit. The full impact of the fall in oil prices will only be noted in the trade and external current account data in the fourth quarter, when export deliveries based on the new lower oil prices will be effectd. But to this evident oil price impact we need to add the fact that the non-oil external current account deteriorated significantly in 2008 as import volumes shot up considerably faster than non-oil exports (the competitiveness problem). In the second quarter of 2008, the non-oil external current account deficit reached almost US 60 billion, and this was followed by a further USD 62 billion in the third quarter, making Russia’s balance of payments position particularly vulnerable to a continuation in the low level of oil and gas prices.

We also need to consider the problems Russia may now have in financing any such current account deficit (remember this one one of S&Ps concerns). The World Bank estimates Russia’s external debt maturing in the third and fourth quarters of 2008 at around USD 100 billion, of which about USD 45 billion is due in the last quarter of 2008. After including on-demand deposits held by the banking sector, the total debt that requires repayment or refinancing may well exceed USD 120 billion. The external debt maturing for the entire 2009 fiscal year is slightly less, at around USD 100 billion. It is clear, however, that some sectors, especially private financial corporations, are going to face challenges in rolling-over their external debt under current conditions. Further, higher prices for debt refinancing are inevitable, and to all of this you need to add-in the sharp drop in the stock values used as loan collateral which will have resulted in sizeable margin calls on lending facilities with 1-2 year maturities.

All in all the World Bank reached the conclusion that the total debt due in the fourth quarter of 2008 could amount to about USD 60-65 billion. Even so, they concluded that systemic risk to the banking sector, while rising, remained limited due to the government’s resolve in supporting the systemically important banks and the sizable package of measures taken to date. It is hard to assess whether or not they are right in this evaluation, but in any event we are all just about to find out, so those of us who don't especially like mysteries won't have too long to wait.

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About

Edward 'the bonobo' is a Catalan economist of British extraction based in Barcelona. By inclination he is a macro economist, but his obsession with trying to understand the economic impact of demographic changes has often taken him far from home, off and away from the more tranquil and placid pastures of the dismal science, into the bracken and thicket of demography, anthropology, biology, sociology and systems theory. All of which has lead him to ask himself whether Thomas Wolfe was not in fact right when he asserted that the fact of the matter is "you can never go home again".
He is currently working on a book with the provisional working title "Population, the Ultimate Non-renewable Resource".
Apart from his participation in A Fistful of Euros, Edward also writes regularly for the demography blog Demography Matters. He also contributes to the Indian Economy blog . His personal weblog is Bonobo Land . Edward's website can be found at EdwardHugh.net.